Showdown In Hong Kong: PCAOB Declares A Win As China-Based Auditors Open Access

U.S. Securities and Exchange CommissionShutterstock
It had all the elements of high-stakes financial drama. Two hundred companies were about to be banished from U.S. markets. One trillion of market cap held by American pension funds and 401Ks was at risk of vaporizing. Angry speeches blasted the floor of the U.S. Congress. Then, last week, the storm passed. At least for now, the delisting clock for Chinese companies has been stopped for three years, according to Gary Gensler, Commissioner for the Securities and Exchange Commission (SEC). The waters seem safe to invest in Chinese equities again. Two decades ago, the Public Company Accounting Oversight Board (PCAOB) was formed in the wake of Enron's meltdown as the 'auditors' auditor' to ensure that independent accountants performed their work with diligence and skepticism. But one group of public companies remained beyond their grasp – issuers audited by mainland China and Hong Kong-based audit firms. These auditors included the local affiliates of the 'Big Four' global giants. Over the years, the SEC and PCAOB negotiated, threatened, cajoled, and threw up their hands in despair. All to no avail. Their counterparts in China, the China Securities Regulatory Commission (CSRC) and the Ministry of Finance, insisted that allowing U.S. regulators to pry unsupervised into the books of Chinese companies would violate China's sovereignty. Among the most prominent companies listed on the NYSE at that time were the jewels of the state-owned enterprises (SOEs), essentially the property of the Chinese Communist Party.

The Holding Foreign Companies Accountable Act was passed by Congress in December 2020. It set a time bomb of three years that would allow the US to delist all Chinese companies listed in the United States if the PRC failed to comply with audit inspections. China then blinked last summer. The PCAOB announced in August 2022 that China had granted permission for unrestricted inspections of Hong Kong-based auditors and China's books. They also allowed auditors to access all working papers used by auditors to verify the accuracy of the company's books and interview them without restrictions. In just a few weeks, 30 PCAOB inspectors arrived in Hong Kong to examine the audit papers and interview the auditors. Initial statements by the CSRC stated that they would 'assist in' the interviews. This raised concerns about the PCAOB staff's ability to do so without supervision. Senior management, investment bankers, institutional investors and senior management waited to see if the inspections were successful. The PCAOB announced last Thursday that they had received full cooperation from the team in carrying out their inspections. They were hard workers. They were meticulous. "PCAOB investigators and inspectors were able view the complete audit work papers without redactions. The PCAOB was also able retain all information necessary to complete our work. This sounds like a win from the perspective of a U.S. regulator. They were able achieve compliance on all the most difficult issues that had been preventing them from negotiating with Chinese counterparts for more than a decade. Under Chair Williams' leadership, who was a former SEC litigator in her early career, PCAOB inspections are now extremely strict. There is progress in collaboration on shared issues, even though the United States and China don't seem to be able to agree on many things. This positive signal about the possibility of other difficult issues being resolved is sent by the effective resolution of the conflict over audit inspections. It shows that each side can approach these problems with a spirit pragmatism, mutual respect and a willingness to work together. We could see a huge rush of listings from China to the NASDAQ or the NYSE in the next year. Prospectus for an IPO contains a lengthy list of 'risk factors' that investors will consider. Risk Factor 2: China's regulators have much to do. They have created a new regulatory framework for overseas companies. The Cyberspace Administration of China is China's top cybersecurity officer and was responsible for closing Didi Global's app in July 2021. This move removes a major risk factor from the industry. China's equivalent of the SEC, the CSRC announced its approval process for overseas listing. This includes companies that use a VIE structure in order to circumvent restrictions on foreign ownership in certain sectors such as media and telecom. Paul Gillis, an expert on China audit issues, is a professor at Beijing International Studies University. He stated that China wants this deal to work. They are not looking for a complete financial decoupling from the US capital markets as they already have many other problems. The recent crackdown on large, private companies has had a devastating effect on the unemployment rate of college graduates. China's government cannot absorb the 8.3 million college graduates each year. Third Risk Factor: The SEC and NASDAQ remain skeptical about any stock listing from the PRC or Hong Kong. There were several micro-cap stock IPOs that saw shares rise by up to 3,000% upon listing, but then collapsed days later. NASDAQ has reportedly placed several small underwriters on a blacklist' and withheld approval for smaller IPOs. Brokerages or buying groups based in Hong Kong may have artificially inflated shares and bailed them out just as momentum traders and retail investors were flooding into the market. We could still see a few higher-quality Chinese companies return to the IPO pool in 2023 as COVID lockdowns are lifted across China. The virus continues to affect Beijing and other cities. Last week, more than half the workers were ill in many of these companies. It could be a very interesting year for investors, given the huge backlog of potential public companies and the possibility of more reasonable valuations following the recent tech bubble.